In order to plan properly for the future, each of us should invest a portion (around 20%) of our earnings. These investments collectively are referred to as a “portfolio.” It should be diversified, so that if a portion of the portfolio takes a hit the effect isn’t felt across the whole portfolio.
In this post, I cover the elements of a diversified portfolio (stocks, bonds, and real assets), the two ways to invest in real assets, and how to value a real estate investment property.
Diversified portfolios contain stocks, bonds, and real assets (definitions from Investopedia):
Stocks: corporations issue this type of security, which signifies proportionate ownership in that corporation. This stockholder is then entitled to that proportion of the corporation's assets and earnings.
Bonds: a fixed income instrument that represents a loan made by an investor to a borrower (companies, municipalities, states, and sovereign governments).
Real Assets: physical assets that have an intrinsic worth. Real assets include precious metals, commodities, real estate, land, equipment, and natural resources.
Stocks, bonds, and real assets are not generally correlated with each other, which is why it is a good idea to include all of these in diversified portfolios. Most investors are familiar and have heard of stocks and bonds, and real assets are not talked about as much, nor are they as well understood.
An individual can invest in real assets in two ways:
By buying financial assets that derive their value from underlying real assets.
By buying the actual asset.
Let’s analyze each of these using real estate as an example. The first method, buying a financial asset that is based on the real asset, is the route most investors are comfortable with because it resembles buying a stock or a bond. Financial assets based on real estate are shares in a Real Estate Investment Trust (REIT). REITs are companies that own and usually operate real estate which generates income, like an apartment complex, for example. Investors can buy shares in these companies and therefore hold real estate as part of their portfolio. This investment offers total returns including dividend returns and price appreciation.
Investors are not as comfortable with the second method, buying the physical asset. Buying a property is riskier than buying shares in a REIT and it’s also a more active investment. On the other hand, some investors (like myself) prefer to have a portion of their portfolio they can see; something that is more tangible than balances in brokerage accounts.
Furthermore, an investment property offers tax benefits, appreciation, and monthly cash flow returns. If an investor finances the property, they will also receive the benefit of having the loan paid down.
The first step in buying an investment property is analyzing it and deciding what a fair price is. There are dozens on analysis tools, spreadsheets, and books available on this topic (trust me, I’ve used a bunch of them). The easiest, quickest, most understandable way to price a property is by using its capitalization rate (cap rate), or the rate of return expected:
Cap Rate = Net Income / Purchase Price
To calculate net income, first start with gross income, like expected rents. Then subtract all costs, like property management, lawn, snow, expected expenses, insurance, utilities, and taxes. What’s left is the property’s net income. Note that financing costs are not included in the net income portion of the calculation. The last step is to divide net income by the purchase price.
In my area, investors accept an 8% cap rate. In other areas of the US, they may look for 10 or 12% .
Below is how my husband and I analyzed our investment property, a duplex. We used Zillow and the advice of fellow real estate investors to estimate rents. We pay our property manager 10% of rents and assume $100 per unit in expenses each month. The tenants pay all utilities, with the exception of lawn (there is no snow removal here in Florida!). We used public records to estimate taxes and a quote from our insurance broker to come up with an insurance estimate prior to purchase.
Gross Income:
Unit 1: $1,000 x 12 = $10,800
Unit 2: $1,000 x 12 = $10,800
Total: $21,600
Less: Property Management: 10% of gross = $2,160
Less: Lawn: 50 x 6 = $300
Less: Expenses/capital expenditure savings: $200 x 12 months = $2,400 (estimated)
Less: Insurance: $1,700
Less: Taxes: $1,700
Net income: $15,040
Cap rate = Net Income / Purchase Price: $15,040/$170,000 = 8.8%
The cap rate calculation is an easy way to get started analyzing investment properties, and that’s the first step to investing in physical real estate. If you’ve always had an interest in investing in physical real estate, do some online searching for properties for sale and analyze a few. You just may find a good deal!